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In an attempt to improve the Long Stock and Levered Bond strategy, we decided to sample different rebalancing periods. As the chart below demonstrates, there is almost no difference between a quarterly or monthly rebalancing. The quarterly rebalancing has a slightly better performance, which is a bonus as it means less slipage and commissions paid as well.

In our last post we discussed the benefits of a simple long stock portfolio with a levered bond position, and how the combined portfolio had lower drawdowns than just being long stocks. Deciding to look further under the hood, we were curious what the exact stock/bond return breakdown was during months where stocks fell by more than 2 standard deviations, going back to 1987.

As it turns out, the S&P return component totally dominates the overall portfolio performance, apparently because stocks are a lot more volatile than bonds. Another way to visualize this is to look at the 12 month rolling correlation between the “just stocks” portfolio and the “stocks + levered bonds” portfolio.

All of this begs the question: why a mix of stocks and bonds in the first place? The whole idea of the combined portfolio, often in a 60/40 allocation, is one of the most common practices on Wall Street. But does it necessarily make sense? There are several ways to approach this question, and as a starting point we’d like to offer the following chart of the rolling 12 month correlation between the S&P 500 and US Treasuries.

Unlike a protective put buying strategy or a long position in Vix futures, bonds have positive carry. The best way to test the merits of a hedging strategy is to compare the individual performances of the market, the hedge, and the combined entity. So we tested the following scenarios: